Relaxing regulations could make next crisis worse

The regulatory pendulum has swung in the banking industry’s favor since the 2016 presidential election.

The industry has seen, for example, the appointment of bank-friendly officials like Randal Quarles and Jerome Powell at the Federal Reserve Bank and Mick Mulvaney at the Consumer Financial Protection Bureau — and these individuals are likely to interrupt, rather than strictly apply, crisis-related regulations. As such, even absent outright repeal, the impact of these rules will be substantially reduced. The relaxation of leveraged loan guidelines enforcement is one illustration of this development.

This swing is consistent with the historically cyclical nature of regulation. Regulation tightens following a crisis, creating a sometimes-justifiable industry backlash — and then loosens during the recovery.

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Low loan losses, rising bank income and heightened competition increase risk appetites during an expansion. The increase is supported by backward-looking risk models, incentive compensation and rising collateral values. The process continues until an adverse event or loss triggers mean reversion. The sharp February market correction is a reminder of mean reversion. The economist Hyman Minsky noted that instability builds during an expansion, as a bubble is a boom until it bursts.

You can make money betting against the end of the world. And you are assured of losing money if you are complacent and ignore the inherent cyclicality of banking, believing “this time is different.” Yet bankers find it difficult to control themselves when risk seems remote and conditions appear favorable. As John Mack of Morgan Stanley argued on the heels of the financial crisis, regulators need to stay more involved. “We cannot control ourselves,” he said.

This problem grows as the last shock becomes more distant. It’s been ten years since the financial crisis and bankers’ sensitivity to risk has been substantially reduced. This is especially true as a number of battle-scarred bankers retire.

Procyclical regulation amplifies the risk appetites of bankers during a bull market and adds to the problem. Banking profits in bull markets depend either on superior underwriting or by assuming more risk than your peers. But increased risk is masked during the market upswing only to manifest itself once the inevitable losses materialize. This is the basis of Alan Greenspan’s “shocked disbelief” that bankers failed to act in the best interests of their shareholders by not reacting to rising risk levels. In retrospect, it should not be a surprise that bankers, who are paid to believe this time is different, fail to see rising risk levels. Resisting this temptation is difficult — and it involves career risk, as Phil Purcell, Mack’s predecessor at Morgan Stanley, learned the hard way.

Currently, it is difficult to envision the end of the bull credit market. Rates, although increasing, are still low, defaults are modest and liquidity is readily available. Nonetheless, we are closer to the end of the cycle than the beginning. The deeper we are into illiquid credits, products and structures, the more difficult it becomes to manage risk. This is compounded as regulatory constraints are relaxed.

Thus, bankers should be careful when they wish for relaxed regulation. They may just get it — along with some unpleasant (albeit unintended) consequences for themselves and their shareholders in the next downturn.

Just because you can now take more risk does not mean you should. Ignoring cycles, extrapolating trends and following aggressive peers for fear of missing out is the road to ruin. And bankers may need all the help they can get from regulators to resist these temptations.